401(k) Taxes: Contributions, Withdrawals & Roth Conversions

The Tax Advantage Nobody Fully Explains

Here is the scenario most people think they understand: you earn $90,000, contribute $10,000 to your traditional 401(k), and you pay income tax on $80,000 instead of $90,000. True — but the mechanism is more specific than that, and the specifics matter.

Traditional 401(k) contributions operate under a salary reduction agreement under IRC Section 402(g). The deduction happens at the payroll level — your contribution never appears in Box 1 (Federal taxable wages) on your W-2. This is fundamentally different from, say, a traditional IRA deduction, which you claim on your Schedule 1 when you file. The 401(k) exclusion benefits you regardless of whether you itemize or take the standard deduction, and it reduces your AGI, which can affect eligibility for other deductions and credits.

One important carve-out: 401(k) contributions are not exempt from FICA taxes. Social Security and Medicare wages (W-2 Boxes 3 and 5) still include your deferrals. You pay 7.65% FICA on the full $90,000, not just the $80,000 after deferrals. Two notable state-level exceptions: Pennsylvania and New Jersey tax 401(k) contributions as wages in the year made, then exempt them on the back end — effectively the reverse of federal treatment.

2026 Contribution Limits at a Glance

According to IRS Notice 2025-67, the 2026 employee elective deferral limit is $23,500 — a $1,000 increase over 2025. This limit applies to the combined total of traditional (pre-tax) and Roth 401(k) contributions within the same plan; you cannot exceed $23,500 across both buckets.

The super catch-up provision, added by the SECURE 2.0 Act of 2022, is one of the most underutilized opportunities in tax planning. A 62-year-old employee in the 22% bracket who maxes out at $35,750 saves $7,865 in federal income tax in a single year — plus reduces MAGI for purposes of ACA premiums, Medicare IRMAA calculations, and other income-tested benefits.

Also note: starting January 1, 2026, high earners with FICA wages above $150,000 from their sponsoring employer must make catch-up contributions on a Roth (after-tax) basis. This is the mandatory Roth catch-up rule under SECURE 2.0, and it applies to 401(k), 403(b), and governmental 457(b) plans.

How 401(k) Withdrawals Are Taxed

This is where many retirees get surprised. Every dollar you pull from a traditional 401(k) is taxed as ordinary income — the same as wages, interest, and pension income. There are no capital gains rates for 401(k) distributions, even if the underlying investments produced decades of capital appreciation. You essentially converted capital gains potential into deferred ordinary income at the time of contribution.

The 2026 federal tax brackets (per IRS Revenue Procedures and Tax Foundation data) apply directly to 401(k) distributions:

One critical planning observation: the single largest bracket jump in the entire 2026 structure for married joint filers is the step from 12% to 22%, which occurs at $100,800 of taxable income. A couple withdrawing large 401(k) distributions while also receiving Social Security benefits can inadvertently cross this cliff, effectively raising the marginal cost of each additional withdrawal dollar by 83%.

When a plan administrator distributes an eligible rollover distribution directly to a participant (rather than rolling it to an IRA), they must withhold 20% for federal income tax under IRC Section 3405(c). This is mandatory — you cannot opt out. Periodic payments such as RMDs, however, are subject only to default 10% withholding, which participants may adjust by filing Form W-4P.

Use our income tax calculator to model how a specific withdrawal amount would affect your tax bracket and overall liability.

The 10% Early Withdrawal Penalty: When It Applies and When It Doesn't

IRC Section 72(t) imposes an additional 10% tax on distributions from qualified retirement plans (including 401(k)s) made before age 59½. This is on top of ordinary income tax — not instead of it. Pull $20,000 from your 401(k) at age 45, and you owe income tax on $20,000 plus a $2,000 penalty. In the 22% bracket, that's $6,400 in total federal taxes on a $20,000 withdrawal.

Per IRS Topic 558 and IRS Publication 575, the following statutory exceptions eliminate the 10% penalty (the distribution is still taxable income):

• Separation from service at age 55 or older — the "Rule of 55" applies to 401(k) plans specifically; it does not apply to IRAs
• Substantially Equal Periodic Payments (SEPP) — must continue for 5 years or until age 59½, whichever is longer (IRC §72(t)(2)(A)(iv))
• Death or permanent disability of the account holder
• Medical expenses exceeding 7.5% of AGI
• Qualified Domestic Relations Order (QDRO) — distributions to an alternate payee under a divorce settlement
• IRS levy on the plan
• Military reservists called to active duty for 180+ days
• Qualified birth or adoption — up to $5,000 per event (SECURE 2.0)
• Terminal illness (added by SECURE 2.0)
• Federally declared disaster distributions (SECURE 2.0 expanded)

The Rule of 55 is particularly valuable for people who retire early. If you leave your employer in the calendar year you turn 55 (or any year after), you can take distributions from that employer's 401(k) without the 10% penalty. The catch: this only applies to the plan from the employer you separated from — old 401(k)s from prior employers still carry the penalty until 59½.

Required Minimum Distributions: The Forced Withdrawal Clock

The IRS does not allow tax-deferred money to grow indefinitely. Under IRC Section 401(a)(9), traditional 401(k) account holders must begin taking Required Minimum Distributions (RMDs) starting at:

• Age 73 — for anyone born between 1951 and 1959
• Age 75 — for anyone born on or after January 1, 1960 (effective 2033)

The first RMD can be delayed until April 1 of the year following the year you turn 73. Every subsequent RMD must be taken by December 31. Note that delaying the first RMD means taking two RMDs in one year — a common planning mistake that concentrates taxable income and can spike Medicare IRMAA surcharges two years later.

RMD calculations use the IRS Uniform Lifetime Table (Table III in IRS Publication 590-B). The formula:

RMDs grow as a percentage of account value each year, even if the account grows at the same rate. A $2 million 401(k) balance at age 73 generates an $75,471 mandatory distribution. At 85, the same $2M account (ignoring growth for illustration) demands $117,647. These forced distributions can push Social Security benefits into taxable territory and trigger Medicare surcharges — making pre-RMD planning critical.

Still-working exception: Active employees who do not own more than 5% of the company can defer 401(k) RMDs from their current employer's plan until the year they retire. This exception does not apply to IRAs or to old employer plans.

Missed RMD penalty: Failure to take a full RMD results in a 25% excise tax on the shortfall (reduced from 50% under SECURE 2.0). This drops to 10% if corrected within the 2-year window. Use our tax bracket calculator to estimate how RMD income affects your overall tax burden.

Roth 401(k) vs. Traditional 401(k): Choosing the Right Tax Timing

A Roth 401(k) uses after-tax dollars — you contribute money that has already been taxed. The payoff: qualified distributions in retirement are completely tax-free, including earnings. The same $23,500 annual limit applies to the combined total of traditional and Roth 401(k) contributions.

The core decision comes down to whether you expect to be in a higher or lower tax bracket in retirement:

Under SECURE 2.0, Roth 401(k) accounts are no longer subject to RMDs during the owner's lifetime (effective for distributions required after December 31, 2023). This brings them in line with Roth IRAs and eliminates a long-standing disadvantage of the Roth 401(k) versus the Roth IRA.

For young workers early in their career, the math frequently favors the Roth: tax rates are low now, decades of tax-free compounding are ahead, and the flexibility of no RMDs in retirement adds meaningful value. For a 55-year-old at peak earnings in the 35% bracket, the traditional 401(k) deferral is harder to beat on a purely mathematical basis.

In-Plan Roth Conversions: Moving Money Without Leaving Your Plan

An in-plan Roth conversion (also called an in-plan Roth rollover) allows 401(k) participants to convert pre-tax or after-tax funds into a designated Roth account within the same plan — without distributing the money and without leaving the plan. The plan must offer a designated Roth account to enable this feature.

Key rules, per IRS Form 1099-R guidance and IRC Section 402A:

• The converted pre-tax amount is fully taxable as ordinary income in the year of conversion
• No 10% early withdrawal penalty — in-plan conversions are treated as rollovers, not distributions
• No mandatory 20% withholding — pay estimated taxes from outside funds to preserve the full conversion amount inside the Roth
• Reported on IRS Form 1099-R with Code G in Box 7
• A 5-year holding period applies before qualified tax-free distributions from the converted Roth balance
• No income limits — anyone can do an in-plan conversion regardless of earnings

The strategic window for in-plan Roth conversions is the same as for IRA conversions: low-income years. Early retirees who leave the workforce before claiming Social Security, people taking sabbaticals, or anyone with unusually high deductions in a given year can convert at a temporarily lower effective rate. See our Roth IRA conversion strategy guide for the full bracket-stacking framework.

The Mega Backdoor Roth: Supercharging Your After-Tax Contributions

The Mega Backdoor Roth is an advanced strategy that allows high earners to move substantially more than the $7,000 Roth IRA limit into a Roth account each year — sometimes $40,000+ more.

The mechanics rely on the gap between the employee deferral limit ($23,500) and the total Section 415(c) annual addition limit ($72,000 in 2026). That gap — minus any employer match — can potentially be filled with after-tax (non-Roth) contributions, which are then converted to Roth via an in-plan rollover or distributed to a Roth IRA. Per IRS Notice 2014-54, only the earnings on those after-tax contributions are taxable on conversion; the after-tax basis transfers tax-free.

Two requirements must be met: (1) your plan must allow after-tax non-Roth contributions, and (2) your plan must allow in-service withdrawals or conversions of those after-tax amounts. Many large-employer plans offer both; many small business plans do not. Check your Summary Plan Description to confirm.

Net Unrealized Appreciation: The Company Stock Tax Break Most People Miss

If your 401(k) holds employer company stock, Net Unrealized Appreciation (NUA) under IRC Section 402(e)(4) can generate one of the most favorable tax outcomes available in retirement planning. Instead of paying ordinary income rates on the full value of employer stock, NUA lets you pay ordinary income only on the cost basis and long-term capital gains rates on the appreciation — regardless of how long the stock was held inside the plan.

Per IRS Notice 98-24, the strategy requires a qualifying triggering event (separation from service, age 59½, death, or disability) followed by a lump-sum distribution of the entire account in a single tax year. The employer stock must be distributed in-kind (as shares) to a taxable brokerage account. Non-stock assets can be rolled to an IRA tax-free.

The tax savings can be substantial. Assume employer stock with a $50,000 cost basis has grown to $500,000 inside the 401(k). Ordinary income applies to $50,000 at distribution. The $450,000 of NUA is taxed at long-term capital gains rates when sold — at most 20%, versus the 37% that would apply if the entire amount were rolled to an IRA and eventually withdrawn as ordinary income. The potential savings exceed $76,500 in this example.

NUA is not universally beneficial. It triggers a large ordinary income hit at distribution, requires taking the full account as a lump sum (foregoing continued tax-deferred growth on other assets), and may generate Medicare IRMAA surcharges. Full modeling is required before pursuing this strategy.

Who Is Actually Using 401(k) Plans?

The 401(k) system has grown into the backbone of private retirement savings in the United States. According to the Investment Company Institute's Q4 2025 data, total 401(k) assets reached $10.1 trillion across approximately 715,000 plans covering roughly 70 million active participants.

Fidelity Investments, which administers nearly 25 million 401(k) accounts, reported that the average 401(k) balance reached $146,100 at year-end 2025 — up 11% from 2024 — while the median balance stood at $34,400, reflecting the skewed distribution. The number of 401(k) millionaires on Fidelity's platform grew to 665,000 accounts. According to Vanguard's How America Saves 2025 report, the average participant savings rate (employee + employer combined) hit a record 14.2%, with 85% of eligible employees participating in their plans.

Access, however, remains uneven. The Bureau of Labor Statistics' March 2025 National Compensation Survey found that 72% of private industry workers had access to employer retirement benefits, but only 59% of workers at firms with fewer than 100 employees had access — versus 90% at firms with 500 or more workers. This access gap is part of the rationale behind SECURE 2.0's automatic enrollment mandates for new plans.

Consider maximizing your contributions using our tax bracket calculator to see the exact tax savings for your income level.

State Tax Treatment of 401(k) Contributions and Distributions

Most states follow the federal tax treatment of 401(k)s: contributions are excluded from state taxable income, and distributions are taxed as ordinary income. But important exceptions exist at both ends:

Pennsylvania and New Jersey tax 401(k) contributions as wages when made — unlike the federal treatment. The upside: PA and NJ generally exempt 401(k) distributions from state income tax when received in retirement, a reverse-timing advantage. For long-time PA residents, this means no state income tax on retirement distributions, which partially offsets the front-end contribution tax.

Several states exempt retirement income from state tax entirely, including Illinois, Mississippi, and Iowa (for those over 55). Others, like California, tax 401(k) distributions at ordinary income rates with no special exemption — applying the state's top marginal rate of 13.3% on top of federal taxes for high-income retirees.

If you are considering relocating in retirement, the nine states with no income tax offer potentially significant savings on 401(k) distributions, depending on your annual withdrawal amount.

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